Many Canadians often wonder whether they should take a personal loan or line of credit. However, there are common misconceptions about how both of them work. In this article, we’ll explain the differences between the two credit products to help you make an informed decision.
Personal loan or line of credit: what is the difference?What is a line of credit?
A line of credit is a predetermined loan that you can access from a bank or alternative lender. You can spend up to a certain amount, with the average limit on the line of credit floating around $8,000. A line of credit differs from a personal loan because you don’t have to start paying interest until you use it.
You can use as much credit as you want (within your limit), as long as you make the minimum monthly payments. A line of credit is considered to be a type of revolving credit, similar to a credit card – but with much lower interest rates. Revolving credit means you have a limit on how much you can borrow, but how much credit you use is up to you.What is a personal loan?
A personal loan is money borrowed from a lender, bank or credit union. It’s a lump sum that is paid back in monthly payments. Personal loans are usually unsecured, meaning, that they are not backed by collateral (a house or a car). While secured loan rates can sometimes be lower, there’s also the chance that if you default on your loan, you could lose those items.
How much you can borrow and the interest rate you receive is determined by things like your credit score and payment history. Borrowell’s annual percentage rates (APRs) on personal loans range anywhere from 5.6% to 29.9%* however, typical loan rates can reach up to 35%.When does it make sense to take a line of credit?
There are many occasions when a line of credit is a good idea. If you’re a business owner experiencing cash-flow problems, or an entrepreneur looking to start a business, a line of credit may be a great option. A line of credit is a great tool to use for everyday expenses, as opposed to a big purchase you’ve been saving up for, so that your spending doesn’t get out of hand.
You’re only required to pay interest on the amount you’ve used, making lines of credit appealing to those who require flexibility. Lines of credit make it very easy to access credit because many lenders provide 24/7 access to your credit online or through a mobile app.
If you’re not looking to pay off debt and you don’t have any issues using credit, a line of credit could be a good choice.What are the dangers of getting a line of credit?
Now you know the pros of a line of credit! But it’s important also discuss the cons when deciding between a personal loan or a line of credit.A line of credit can be overly accessible
As mentioned above, a line of credit is sometimes viewed as ‘too accessible’ because there isn’t a structure or the same scheduled payments each month. A line of credit requires a lot of discipline, which isn’t easy if you’re borrowing money.
It can be tempting to keep spending without a budget.Variable interest rates
A line of credit may come with a low-interest rate. This is because lines of credit have variable interest rates, which means the interest rate can increase or decrease along with the bank’s prime rate. If the bank’s prime rate increases, then you may have to pay more in interest.Revolving credit counts towards credit utilization
A line of credit is also considered to be revolving credit, which is factored into your total credit utilization. Credit utilization is the percentage of credit you’re using of your entire available credit. You can figure out your credit card utilization by dividing your total credit card balances by your total credit card limits. Most lenders and lenders like to see this number below 30%.
Revolving credit, as mentioned above, means you have a limit on how much you can borrow, but how much you use is up to you. Instalment credit, like a personal loan, is a credit account that you borrow a sum of money and then make fixed payments on the sum (including interest). Instalment credit is not factored into your total credit utilization and can look favourable to lenders because fixed monthly instalments can demonstrate creditworthiness.When does it make sense to take a personal loan?
Many Canadians will consider a personal loan in their life at one point or another. A personal loan could be used for paying off your credit card debt to save on interest payments, debt consolidation (to pay off multiple debts with a larger loan to create one easy monthly payment), expanding your business, funding your wedding, improving your home, making a big purchase (like a car) or to cover moving costs.
Let’s dig deeper into a few scenarios where a personal loan could work for you.Using a personal loan to get out of credit card debt
Credit card debt – and how to get out of it – is a major issue for Canadians. The latest numbers from Equifax show that Canadians, in total, carry about $90 billion in credit card debt. Most credit cards have annual percentage rates that typically range from 19.99% to 29.99%, so if you fall behind on payments – the interest rates make it very difficult to catch up.
When using a Borrowell loan to pay off credit card debt, a Borrowell customer will typically save a few thousand dollars on interest compared to borrowing from a credit card.* Plus, you can choose a loan term of either 3 or 5 years, so you know when you’ll be out of debt and have a specific payment plan to follow. We recommend using a loan calculator to find out how much you could save.Using a personal loan to consolidate debt
Debt consolidation is when you take a new, larger loan to pay off a number of smaller debts, loans, and bills that you’re making payments on. Debt consolidation brings together these numerous debts to create a combined loan and only one (easy) monthly payment.
That said, debt consolidation makes sense if the APR of the new loan is less than the interest rate of the other debts you would like to pay off. For example, let’s say the APR on a Borrowell was 10% and you were $10,000 in various debts. You could save close to $5,000 in interest and pay off your debt 30 months sooner.*What are the dangers of taking a personal loan?
Just like taking a line of credit, personal loans also come with some challenges. If you take a personal loan, you must still budget and stay on top of your payments. A personal loan requires budgeting, planning ahead, and self-restraint.
If you have problems following scheduled payments in order to get out of debt, a personal loan may not be the best option for you.The Bottom Line
Credit, whether it be a personal loan or line of credit, is a great tool to help you achieve your financial goals. If you’re using a line of credit in order to pay off debt or consolidate debt, you should exercise caution. Due to the revolving nature of a line of credit, it’s easy to get carried away and end up taking on more debt than anticipated.
If you’re looking to pay off credit cards or consolidate debt, a low-interest personal loan may be a better option.
Borrowell helps Canadians make great decisions about credit. Borrowell offers free credit score and report monitoring in Canada. With personal loans and financial product recommendations, Borrowell empowers Canadians to improve their financial well-being and be the hero of their credit.
*Credit card calculations assume a 3-year loan term and that you are comparing a credit card balance of $10,000. Credit card calculation assumes you are making a fixed monthly payment on credit cards at an APR of 19.9%. Making the minimum monthly payment could mean it will take longer to pay off your credit card(s).
Editor's note: This post was originally published in December 2018 and has been updated for accuracy and comprehensiveness.